A first step toward righting the balance between static and dynamic benefits in the welfare analysis of mergers is to see how a merger might lower the costs of R&D or in other ways increase merging firms’ abilities to innovate successfully. There are at least three types of effect that merging parties might assert would occur: (1) increased capabilities realized by combining complementary assets; (2) larger firm size, which somehow gives rise to a greater ability to
absorb the risks of or fund R&D; or (3) less competition and greater product-market profits, which can then fund R&D. We address these effects in order.
With respect to combining complementary assets, a fundamental issue is whether an alternative means (e.g., licensing of complementary intellectual property) can achieve the same efficiencies without removing a competitor. Mergers have specific institutional features that may give rise to certain advantages in facilitating the exchange of complementary assets. For
example, Professor Oliver Williamson has shown that under some conditions, merged ownership may reduce transaction costs of exchanging goods and services compared to less integrated forms of governance like contracts or joint ventures.115 Available research shows, however, that the issue needs careful attention on a case-by-case basis.116
Turning to the second type of effect, considerable debate surrounds the relevance of firm size for innovation.117 Following Schumpeter, some observers have praised large enterprises for their superior ability to attract financial and human capital, bear the risk, and recoup the
investment required for sustained R&D activities.118 Other analysts tout small firms as being more creative than larger, more bureaucratic enterprises.119 Many empirical studies have addressed the relationship between firm size and innovation. Most recent research yields a consensus that, in general, R&D rises only proportionally, and only up to a point, with firm size.120 The strength of the causal relationship between firm size and R&D, however, remains somewhat questionable despite the observed correlations. Because many variables correlate with
115 Oliver E. Williamson, Markets and Hierarchies (1975).
116 For a general comparison of alternative institutional arrangements, including merger, see Katz, Michael L.
(1995) “Joint Ventures as a Means of Assembling Complementary Inputs,” Group Decision and Negotiation 4: 383-400. For a survey of empirical research testing transaction-cost hypotheses see Shelanski, Howard A. and Peter G. Klein (1995) “Empirical Research in Transaction Cost Economics: A Review and Assessment,” J. L. Econ. & Org. 11: 335-361.
117 For an overview of the ambiguous relationship between firm size and innovation, see Cohen, Wesley M., and Steven Klepper (1996) “A Reprise of Firm Size and R&D,” The Economic Journal 106: 925-51.
118 Galbraith, John Kenneth (1952) American Capitalism: The Concept of Countervailing Power, Boston:
Houghton Mifflin, and Nordhaus, William D. (1969) Invention, Growth, and Welfare: A Theoretical Treatment of Technological Change, Cambridge: MIT Press.
119 Morton I. Kamien and Nancy L. Schwartz (1982) Market Structure and Innovation, Cambridge: Cambridge University Press, and Cohen and Levin (1989, supra note ___, at 1067).
120 Scherer, Frederick M. (1965) “Firm Size, Market Structure, Opportunity, and the Output of Patented Inventions,” American Economic Review 55: 1097-1125.
firm size, it is unclear in many studies whether firm size itself is a statistically significant factor in innovation. Although early studies did purport to find significance,121 others have found that, when other firm and industry characteristics are factored in, firm size does not significantly affect R&D investment.122 When the focus of analysis shifts from innovation inputs such as R&D expenditures to outputs such as patents, large firms show no advantage over small ones.123 Data matching R&D investment with patent output have in fact shown that smaller firms produce more innovations per R&D dollar and per employee than do large firms.124
The evidence overall thus suggests that, to the extent firm size has an effect on innovation, its magnitude and direction depend on associated industry-level variables and are susceptible to few general presumptions. The results suggest that especially large firms have no special tendency—nor any predictable reluctance—to engage in innovation, and that small, fringe firms may play important roles over time in technologically advancing markets.125
Lastly, consider the argument that greater product-market profits make it possible for firms to conduct additional R&D. The profits-innovation linkage has two interpretations. One is that the potential for product-market profits generates innovation incentives. This interpretation concerns competitive effects and was addressed earlier in Section III where we discussed the complex link between market structure and innovation. The other interpretation is that current profits can generate free cash-flow to finance R&D efforts. Because this interpretation is loosely a statement about the production of innovation, rather than incentives, we will treat it here as an efficiency-based claim. A first observation is that a remarkable and dangerous lack of a limiting
121 Cohen and Levin (1989), supra note ___.
122 Cohen, Levin, and Mowery (1987), supra note ___, and Cohen and Levin (1989), supra note ___.
123 Fisher, Franklin, and Peter Temin (1973) “Returns to Scale in Research and Development: What Does the Schumpeterian Hypotheses Imply?” Journal of Political Economy 81: 56-70, Kohn, M.T., and J.T. Scott (1982) “Scale Economies in Research and Development: The Schumpeterian Hypothesis,” Journal of Industrial Economics 30: 239-49, Acs, Zoltan, and David Audretsch (1990) Innovation and Small Firms, Cambridge: MIT Press, and Acs, Zoltan, and David Audretsch (1991) “R&D, Firm Size, and Innovative Activity,” in Innovation and Technological Change: an International Comparison, Acs and Audretsch (eds.), Ann Arbor: University of Michigan Press.
124 Acs and Audretsch (1991), supra note 123.
125 See, e.g., Baker, Jonathan B. (1995) “Fringe Firms and incentives to Innovate.” Antitrust Law Journal 63:
621-41.
principle exists in this argument. By this argument, for example, why not grant a firm a
monopoly in a completely unrelated market to generate the cash flow needed to conduct R&D in the market of concern? Second, given the overall efficiency of U.S. capital markets, this
argument is inherently suspect. It is not surprising that, in their review of the empirical literature some years ago, Kamien and Schwartz found that "[i]n sum, the empirical evidence that either liquidity or profitability are conducive to innovative effort or output appears slim."126
Thus, neither the evidence on firm size nor that on profitability supports any presumption that mergers will enhance R&D investment or make that investment more productive.
Assessments of efficiency benefits for innovation will therefore likely turn on the analysis of whether the merger under consideration allows the combination of complementary assets that would not otherwise be combined through a means posing less of a threat to competition. We now return to this question in greater detail